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Oil Addiction and Volatility

To continue with the idea of why oil dependence should be avoided, we will explore how oil volatility and macroeconomic performance have shared a relationship in the past. The volatility in the oil market is referencing the price of oil and therefore, when we are analyzing this relationship we are looking at how significant changes in oil market prices have impacted economic performance.

Economist James Hamilton has done some very interesting work in analyzing energy economics and has in his research has found that out of the past 11 US recessions, 10 of them were preceded by oil price shocks. Hamilton does not try to assert that there are the only reason a recession occurred, but rather they act as the “push” over the edge of an already teetering economy.

This is a very important understanding for anyone trying to develop an opinion of the role of oil in energy markets. Oil has a vast amount of power. The photo to the left shows a fascinating relationship between oil and GDP. GDP requires production, production requires energy and much of energy relies on oil. It is fairly simple, and the graph shows the power of oil on an economy better than I can explain.

To further develop this point, I want to reference a study I found while working on a research paper about this topic. The study found that for every 10% increase in oil price, the US economy would contract by .5%, a significant number, especially considering that it is not uncommon to see times when the oil prices are increasing by much more than 10%.

We shouldn’t need too much more on this issue than combining this basic insight into our experiences. The 1973 OPEC embargo experience gave rise to a quadrupling of the market price and a few years later the Iranian Revolution resulted in a doubling of the prices. These are just two examples of times when oil supply was vastly changed and thus led to economic downturn, how about one more example from the demand side. Hamilton again writes about this topic and the more recent recession of 2007 which saw significant increase in oil prices was due to a stagnation of demand which led prices up.

The reason I wanted to provide some simple examples of both demand and supply shocks is because it emphasizes the idea that oil volatility can be due to a variety of shocks. It could be political unrest in the Middle East or a War or a slow down in production, and they all end up with the same result; economic downturn. We will continue to explore this issue, and if you are interested in this idea post a comment and I will be happy to do what I can to provide some insight.